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Inventory Reduction: Bringing Your Working Capital Cash Back to Life

Inventory is a fact of manufacturing life. It is accumulated and maintained for raw materials, work in-progress (or WIP), and finished goods. We like inventory when it means we can be highly responsive when the customer needs us to be. We don’t like inventory when we start to realize that it a) ties up a substantial amount of working capital, b) can be expensive to store and maintain, and last but not least, c) it weakens operational discipline – meaning is cultivates manufacturing and supply chain inefficiency. Thus creating a double-edged sword where you could get burned quickly for not having enough inventory and you get burned in the long run for having too much inventory. The Ideal state would be to not need inventory at all, but this would require you to have a supply chain that can deliver orders on-demand. This means having the right products at the right place in the right quantities and so on. This means immaculate execution on the part of your supply chain in terms of speed, quality, and reliability. Although this is an ideal state and not within short-term reach for most (if any) companies, it should be the ultimate goal of any company’s Continuous Improvement path to world-class execution.

Inventory accumulates for a few main reasons, including but not limited to: unpredictable demand, over-purchasing, over production, unreliable manufacturing / supply chain processes, insufficient manufacturing capabilities, insufficient manufacturing capacities, lack of agility, and a whole host of other reasons. The main thing to understanding is that all of these reasons are driven by addressable gaps in performance; which are ultimately resulting in a “push” manufacturing model. If a company is maintaining any level of inventory, you can be assured that they are suffering from at least one of the items on this list if not multiple. The system-level key to reducing or eliminating the need for inventory is to close performance gaps in these and other related areas.

With that said, some of the root causes that result in the need for increased inventory levels cannot be resolved in the immediate future. You may find yourself with a need to reduce inventory levels drastically within 6 months to a year. It is not realistic, for example, to expect drastic changes in manufacturing capabilities or capacities in such a short time frame, especially if you don’t have the capital readily available to make significant engineering changes. For this reason, I typically recommend a time-phased approach to reducing inventory levels that drives both immediate gains and sets the supply chain on a path to world-class execution. The phases are as follows:

Phase 1 – Crisis Mode – Fire Sale: The goal here is to minimize the damage of further obsolescence which is what happens when excess inventory expires or is no longer demanded. The best case is to aggressively seek new customers who will absorb the excess (and/or obsolete) at full rate. The next best case is to offer the overages to the highest bidder. Another approach would be to donate excess or obsolete product (if applicable) and write-off losses.

Phase 2 – Short Term – Safety Stock Implementation: Apply appropriate safety stocks and tie inventory levels to demand. In Lean terms, this is an intermediate step to creating an actual pull system called a supermarket. Once the initial wave of excess / obsolete inventory has been reduced, the next step is to determine and implement the appropriate safety stocks. Safety stocks are determined through an algorithm of past sales (considering seasonality), expected future sales, and plant production capability among other variables. In this model, the production schedule should be driven by replenishing safety stock levels.

Phase 3 – Medium Term – Safety Stock Optimization: Match inventory to demand by SKU and apply additional reduction based on your factory / supply chain’s delivery capability. In order to execute this phase, you need to understand your factory and supply chain’s capability by SKU. It also requires categorization of product SKU’s into active (A), slow-moving (B), and excess / obsolete (C). A thorough analysis can help to determine the optimal levels of SKU’s in each category considering manufacturing performance and capability. Again, the production schedule is driven by safety stock replenishment requirements. The next step in the process is to provide suppliers with safety stock status information so that their production schedules can be driven by your needs for stock replenishment. This along with synchronizing with your customers effectively establishes a pull system, which the ultimate method for controlling inventory levels.

Phase 4 – Long Term – Inventory Quality Ratio Implementation: Implement the Inventory Quality Ratio (IQR) model that strives to minimize slow moving and obsolete items and maintain active items – measured as a percentage. IQR = Active Inventory Dollars / Total Inventory Dollars; in other words, the IQR would be 100% if all inventory were active. The definition and speed of turns of “active inventory” varies by industry but is generally the fewest number of SKU’s that makes up 80% of units sold. The IQR is a metric that can be implemented immediately or at any of the prior phases; however, the phases leading up to this one provide the foundation and information needed to implement IQR, which then lends itself to eliminating excess or obsolete inventory altogether. For slow moving SKU’s, the supply chain needs to be made reliable enough to execute effectively.

Ideal State – Ultimate Supply Chain / Demand Alignment: Match manufacturing and supply chain capabilities with demand to the point where orders could be filled on-demand with no inventories required. This is the classic model of “don’t even make it until after it’s been ordered by the customer”, which constitutes a pull production system in the purest form. This requires developing your manufacturing and supply chain processes to levels of world-class execution, or 85% OEE. This requires tremendous Operation Discipline and should be the ultimate aspiration of any Continuous Improvement program. Ease of implementation of this model depend heavily on the predictability of demand, but with the right science and analytics, any manufacturer can reach heightened levels of success.

Manufacturers need to establish an effective balance between supply chain reliability, safety stocks, and market demands. Inventory builds as a reaction to supply chain processes being incapable of meeting orders on-demand and the use of a push manufacturing model. In an ideal state, the customer could place an order, the factory could make the product and fill the order shortly afterward, and deliver it on time and in-full to the right location; this defines the supply chain’s level of execution. However, what actually happens is that manufacturers build inventory so they don’t have to rely on their supply chains to deliver within such a short window of time, risking failure to meet customer service expectations. Over time, this practice encourages greater and greater inventory levels, which only serves to hide the very inefficiencies that result in needing the inventory in the first place. Without effective inventory management systems, there is no check and balance to continuously drive down inventories, freeing up working capital (cash) that can be used for more productive purposes. A manufacturing efficiency expert such as those at Manuficient can help you strike the right balance between supply chain reliability, safety stocks, and market demands to drive significant reductions in inventory costs. Also, Manuficient can work with you to increase supply chain reliability, resulting in additional working capital availability.